Greed vs. Fear: Making Sense of the Market Crash

Presider:
Benn Steil, Senior Fellow and Director of International Economics, Council on Foreign Relations

Wilbur Ross, Japan Society Chairman and CEO of WL Ross & Co., spoke at the Society about long-term solutions for some of the problems confronting the U.S. and the global economy.

"Markets are a constant struggle between greed and fear, as data are transformed into emotions and those emotions get translated back in securities prices," Mr. Ross said.

In the U.S., we won't get quick relief from high unemployment and underemployment rates, currently 9.1 and 16 percent, respectively. "With capacity utilization below 75 percent, corporate cash will continue to be used to substitute capital for labor and for overseas investment," a change that is "permanent, not just cyclical."

"Technology is key to our future growth, but unfortunately we are dumbing down our students, not preparing them for good jobs," he said. "We graduate about one-seventh as many engineers and scientists as India and China combined, and many of our graduates are foreign nationals who can't get the visas to remain here. Why deport brains and import their output? Our immigration policy should welcome them so we can export their products."

The Obama administration's stimulus proposals are far from a good bargain in terms of job creation. "A better solution, although one that would require a lot of boldness on the part of Congress and the administration, would be to substitute for all of our present federal corporate and individual income taxation a national value-added tax on imports and on goods and services produced and consumed within the U.S.," Mr. Ross said. The tax would be rebated on exports. With a standard rate set at 20 percent—more for luxury items and zero or nearly zero for low-priced necessities—the VAT "would yield $94 billion of additional tax revenues at little cost to Americans."

"With no income tax, we could offer visas to reputable foreigners who bought a home for say at least $200,000 in the U.S. and committed to forego permanently all government benefits. If just 500,000 people accepted, America would receive $100 billion of capital infusion, and if each of those new residents spent $12,000 a year, there'd be $1 billion more VAT and $5 billion a year of consumer spending."

In Europe, "the Club Med countries—Greece, Portugal, Italy and Spain—need very fundamental economic restructuring" to raise productivity, cut back on the government workforce and encourage companies to make new hires.

Regardless of how the Greek crisis is solved, "I believe that a multi-trillion euro support facility is needed to prevent a domino effect to Spain and Italy, having serious consequences," he said. "European banks' stress tests were a joke. For example, the ECB said the Irish banks would need 3 billion euros. So far they have consumed 35 billion euros, almost 12 times as much as the stress test indicated."

"Longer term, there must be more complete financial integration of Europe with some form of central control over fiscal policy, but compromising the sovereignty of individual nations will be very difficult. It's more likely that sovereign debt issuance will somehow be tied to meeting budgetary standards."

Exports from China to Europe and the U.S. exceed 4 percent of China's GDP, "so western recessions would have an impact, but not a gigantic one—probably less than a percentage point in terms of Chinese GDP growth," Mr. Ross said. Residential real estate isn't as leveraged in China as in the U.S. And "the U.S. economy was already slumping when housing collapsed, but China is not. So, a few overleveraged developers will fail, but we will not have the massive foreclosures that are being experienced in the U.S."

A bigger threat comes from special-purpose vehicles set up by Chinese municipalities to fund infrastructure. Some 25 percent of the $1.7 trillion in securities is backed by "dubious real estate projects." Local governments aren't formally on the hook, but "local officials probably will accept some sort of moral responsibility for the problem, and my guess is they'll find a way to repurchase some of the properties or at least to spread realization of the losses over many years."

Only 13 percent of China's land area is arable, so the country has to import food. "China also must import petroleum, iron ore, metallurgical coal, nickel, copper and natural gas, most of which have risen sharply in price because of emerging market demand. Continuing increasing foreign exchange value of the RMB will help some, as will, again, long-term development of China's shale gas reserves, probably the world's largest."

"Half of China's exports still come from relatively unskilled labor, but China has begun to do things like exporting ships and ultimately automobiles instead of just exporting steel. So, that's making much higher valued-added exports out of the same dollar of imported raw material." The country's patent applications "are growing much more rapidly than either Japan's or the U.S." China leads the world in wind and solar technologies, and is moving into aerospace.

All in all, Mr. Ross said, "China's growth may slow to 8 percent, or maybe even 7 percent as the malaise in the West spreads. It won't be the 9 percent to 10 percent of recent years, but I really don't see that a collapse is imminent."

"The European sovereign debt and the global equity markets I believe have priced in very bearish scenarios. So, unless things truly spiral out of control, the worst is probably over for the markets," Mr. Ross concluded.

"My long-term approach is to try to decide which stocks have a real long-term future, and buy when they seem closer to the bottom than the top. I believe that eventually greed will prevail over fear. And if I'm wrong, there will be a different speaker here next year."

***

Benn Steil of the Council on Foreign Relations, who moderated the discussion, posed the first questions:

What can we reasonably expect between now and the election next year? The markets will focus for example on the deficit commission, which is supposed to report in November on a plan for $1.5 trillion in new deficit reduction.

Even if the commission comes up with a consensus—unlikely in view of its members' opposing ideologies—"there is a high probability that it will be ignored anyway," Mr. Ross replied. Assuming Congress fails to meet its December deadline, "I'm not so sure that those [automatic] cuts are very intelligently distributed.... None of this adds up anything like a stimulus program in any event."

When S&P downgraded U.S. sovereign debt in August, we had the financial media saying that our borrowing costs would surge. Instead we had a major stock market selloff and a so-called flight to safety, a flight to U.S. sovereign debt. How does one make sense of this?

"I felt it would be bad for equities, because it would frighten people, but that there would be the flight to quality—so-called quality" in the debt markets, Mr. Ross said. The simultaneous flight to Treasuries and to gold was contradictory. "It seemed to me that the market was just groping for where do they hide from equities."

If a Greek default is inevitable, how do we actually put up firewalls around it? Because a Greek default is one thing. A Spanish default or an Italian default would be catastrophic.

"If I were the EU, I would announce something like a $5 trillion ring fencing in between the peripheral sovereigns and the banks, because that will be such a large number that nobody would ever imagine that it wouldn't be enough to solve the problem," Mr. Ross said.

The worry is that in order to get its 17 countries to agree—"imagine if we were managed by 17 Nancy Pelosis and 17 Newt Gingriches, think how hard that would be to get concerted action"—the EU "will come with some smallish thing that wouldn't convince anybody, and will eventually end up creating a much bigger problem than before."

"Imagine the banking crisis we would have had here if there had been no TARP put in. Things could have been very, very, very severe here in my view."

Even if this $5 trillion firewall were to be erected, significant fiscal reforms will be necessary in these peripheral countries.

Mr. Ross agreed, but pointed out that "fiscal austerity is the exact reverse of the stimulus. So, while it's important and it's necessary long term, it will exacerbate any near-term weakness."

Are the U.S. and Europe on the way to becoming Japan, entering an extended era of very low growth, perhaps even persistent deflation, and political inertia?

"Japanese corporations, to the same extent almost as American, are very cash rich, very liquid.... Economists sometimes forget that liquidity is not just a physical thing—the presence of a lot of cash. Real liquidity is a mindset, and it's a mindset of being willing to deploy the cash. That mindset is lacking in Japan and it's lacking in corporate America right now. And if we could somehow change that mindset, that probably would be the fastest stimulation to both economies."
Members of the audience joined in the Q&A:
What is your long-term view of the European Union as a concept and the consequences for the currency?

What began as a political concept "needs to become, in my view, a true economic concept," Mr. Ross said.

Without "some commonality that bridges all these gaps" between divergent economies, "there will be these tensions all the time. It's fundamentally a conceptually unsound idea to have centralized monetary policy and decentralized fiscal policy. That's half a chicken and half a duck. It doesn't work."

Given cash-rich companies and a strong yen, do you see growth in U.S. acquisitions by Japanese companies?

For historical reasons there has been much less M&A activity even within Japan than in the Western world, Mr. Ross responded. However, "just as it's been I think a good strategy for China to be buying natural resource companies in Africa, in Latin America and even in North America, it might not be the world's worst strategy for Japanese companies to do that and help address the import problem."

Take us out five to 10 years. How do you see the role of the U.S. dollar evolving vis-à-vis its nearest competitors, including the Chinese renminbi?

"I don't think the Chinese want to be the reserve currency for the world," Mr. Ross answered. Eventually, what's "more logical and would work from the Chinese point of view and may well be inevitable" is some system of special drawing rights composed of dollars, RMB, yen, euro, and "maybe some component Australian dollar, some component sterling, maybe some component Korean won or some other currency."

China now allows two firms, Mr. Ross's being one, "to create these so-called dim sum bonds in Hong Kong where we have ETFs, exchange traded funds, so you can participate in RMB-denominated debt securities. That's a very big step."

"Part of the reason why we have been able to get away with our deficits and away with our Treasury funding has been that we are the reserve currency, and therefore the central banks all have to put a lot into that currency. So, if you're talking a 10- or a 20-year period, the probability of our still being the reserve currency I think is relatively small and it will have some implications out there."